Wednesday, June 23, 2010

Breaking Down a Put Spread



Suppose you like the current fundamental and technical outlook on gold and are considering throwing in your lot with the ever hopeful gold bugs. But with the SPDR Gold Shares (GLD) trading at $121 per share, let's say you're a bit skittish at the hefty price tag. While bullish risk rockets or other long stock strategies may be outside your price range, the cheaper vertical spreads may be an alternative worth your consideration. Let's breakdown an out-of-the money put vertical sell on GLD.

In choosing which month to use when structuring this play, some traders opt for front month options which offer an alluring higher rate of time decay. But remember these short term options aren't always sunshine and lolly pops, as they also include the often forgotten (or at least downplayed) gamma risk. Those favoring lower gamma risk over a higher theta typically prefer using longer dated options such as two or three months out. We'll go ahead and use August in today's example.

When it comes to strike selection, traders are faced with the dilemma of either going for a higher net credit and lower probability of profit or a lower credit and higher probability of profit. Suppose we settle on a happy medium between the two by going far enough out-of-the-money to feel comfortable with the profit zone, but close enough to still receive a sufficient return. Consider the risk graph of the Aug 115-110 put spread below.

[Source: MachTrader]

Provided GLD remains above $115, we stand to gain $89. While traders can certainly hold to expiration to capture the whole enchilada, it's usually prudent to exit when the majority of the profit has been achieved.

For related posts, readers can check out:
Ratios, Ratios, and More Ratios
Public Enemy #1
Time to Shine?

1 comment:

Penny Stock Newsletter said...

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